The Crystal Ball Is A Little Hazy

The Federal Reserve Open Market Committee (FOMC or Fed) meets eight times a year, approximately every six weeks, to discuss and set monetary policy. But just prior to four of those meetings, right around the end of each quarter, the FOMC participants submit projections for five key economic variables. These variables are; real output growth, unemployment rate, overall inflation, core inflation, and short-term interest rates (Federal Funds Rate). Their projections cover three years, as well a longer-term prediction. The projections for short-term interest rates are published without attribution to which participant is making the forecast. All the participants’ rate predictions for current and future years are shown in a graph, fondly referred to by fed-watchers as the “dot plot” chart. The most recent dot plot chart is shown below.

FOMC participants assessments of appropriate monetary policy. Midpoint of target range or target level for the federal funds rate
Fed-watchers wait anxiously for the dot plot charts to be issued each quarter. We tend to think of the Fed as being omnipotent and omniscient. But how all-knowing are they actually? How good are they at predicting the future path for the rates they control and set? Not very good at all it seems.

Let’s look at year-end forecasts for short-term interest rates by the FOMC, projecting them forward historically compared against a graph showing where short-term interest rates really went. We use three-year forecasts, using the first three years out from the current year for our plotting. Also, we use the median rate forecast of the participants for each of the years for the sake of simplicity.

The below chart shows the historical Federal Reserve Open Market Committee (FOMC) December median 3-year rate forecasts as compared to the actual effective Federal Funds rate. We can see that the FOMC’s forecasts have often missed the mark, overestimating the actual path of interest rates that ensued in later years after their forecasts. The Fed’s dot plot projections in 2013 through 2015 were particularly poor indicators of actual interest rates. For example, in December 2014, the Fed projected a 3.625% rate by December 2017, yet here we are in April 2018 at 1.51%. To the Fed’s credit, forecasts made in 2017 and 2018 have lined up much better with actual. However, given the Fed’s history of overshooting actual rates in its forecast, we consider it a relatively safe bet that interest rates will end 2018 no higher than the projected level of 2.125%, and quite possibly lower.

Perhaps the biggest problem with the dot plot, and the way even minor shifts in Fed rate forecasts have impacted the stock market in recent years, is a lack of clarity regarding what the Fed is trying to accomplish with its forecasts. Looking at the individual Fed members’ projections in the first chart above shows the wide disparity in forecasts. What the dot plot doesn’t convey is the confidence interval implied in the Fed’s forecasts. The Fed has done a relatively poor job helping investors interpret the dot plot. Former Fed Chair Janet Yellen tried to address the topic during her 2017 speech at Jackson Hole, in which she discussed the inherent uncertainty in making interest rate projections.
Around the same time, the Fed also released the below chart, which demonstrates the confidence intervals, the bands of possible rate outcomes which the Fed believes to be 70%, and 90%, likely.

Confidence intervals, the bands of possible rate outcomes which the Fed believes to be 70%, and 90%, likely.Chart courtesy for the Federal Reserve

The above chart is more than a year old, but illustrates the wide range of outcomes that the Fed considers possible. While the long-run median rate falls around 3%, the Fed is not assigning any degree of certainty to that forecast, rather it is only willing to commit to a 70% certainty that future rates will end up in the range between ~0.5% and ~6% – not much of a forecast! Unfortunately, this message has largely fallen on deaf ears, and we continue to see significant reactions from equity and fixed income markets in response to each new dot plot release.

So, while the markets have recently shown a fear of the FOMC’s forecast for higher rates, the truth is that no one can predict with any degree of consistent accuracy where rates will go in the coming year(s). If the Fed isn’t confident in its own forecast, why should investors be? Perhaps it’s time for the Fed to put the crystal ball away?

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